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Geithner recovery plan too cautious?

Some leading economists say bank rescues should come with tougher conditions, and that the industry is short on capital to cover losses.

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Joseph Stiglitz, the former World Bank economist and Nobel Prize winner, said on Tuesday that the Treasury plan to buy bank assets will result in a transfer of wealth of from taxpayers to the firms, because of incentives that will boost the price banks can get for troubled loans.

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Concerns about the Geithner bank plan have been loud enough that President Obama decided to address them directly in a speech on the economy last week. He drew a distinction between the way the Federal Deposit Insurance Corp. (FDIC) intervenes at small or mid-sized banks and the way larger banks should be treated.

“We believe that preemptive government takeovers are likely to end up costing taxpayers even more in the end," Mr. Obama said. "It's more likely to undermine than create confidence,” Obama said.

A prompt response, not a preemptive one, is the appropriate course, many finance experts say. A financial crisis tends to grow more costly over time, and to impose higher costs on the economy.

The hearing at the Joint Economic Committee was focused on how to set up a framework – lacking in current law – for regulators to intervene when large and complex financial institutions are in trouble. In the Lehman Brothers case, this meant the firm entered a messy bankruptcy process that rattled credit markets worldwide.

“Allowing large financial firms to fail can seriously damage our economy,” Rep. Carolyn Maloney (D) of New York said as she opened the hearing. “On the other hand, unconditional support for large failing firms can be just as dangerous …. Allowing firms to escape the consequences of bad business decisions could prompt even riskier behavior.”

She and others in Congress are trying to develop a new legal framework so policymakers will have a choice between the extremes of bankruptcy and bailout for large firms.

Whether government takeovers are a step along the way or not, finance experts say that the banking industry needs more capital in order to pave the way for solid economic growth in the years ahead.

The IMF forecasts that banks will be charging off bad loans this year and next at a pace not seen since the 1930s.

With voters souring on the rising tab for financial bailouts, one risk is that the needed capital won’t be available from government. Still, it’s possible that the results of so-called “stress tests” of major banks, to be released soon, could provide political cover for Obama to seek more money from Congress. Geithner also says the Treasury has untapped rescue funds exceeding $100 billion.

The stress tests could also draw a brighter line between healthy and weak banks, making it easier for the healthy ones to raise capital from private investors.

Kyle suggests that the Treasury call on banks – even healthy ones such as JP Morgan Chase – to raise lots of capital now, so they’ll be able to lend despite the rising loan losses.

The healthy banks may not like this, because it would dilute the value of stock owned by their current shareholders. But failing to take strong action, Kyle says, “perpetuates and worsens the recession that we’re in.”